Chapter 4

The Time Value

of Money

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Chapter Outline

1.The Timeline
2.The Three Rules of Time Travel
3.Valuing a Stream of Cash Flows
4.Calculating the Net Present Value
Perpetuities, Annuities, and Other
5.Special Cases

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Chapter Outline (cont’d)

6. Solving Problems with a Spreadsheet

Program
7. Solving for Variables Other Than
Present Value or Future Value

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4.1 The Timeline

• A timeline is a linear representation of the

timing of potential cash flows.
• Drawing a timeline of the cash flows will
help you visualize the financial problem.

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4.1 The Timeline

Assume that a friend owes you money. He

has agreed to repay the loan by making
two payments of $10,000 at the end of
each of the next two years.

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4.1 The Timeline

Assume that a friend owes you money. He

has agreed to repay the loan by making
two payments of $10,000 at the end of
each of the next two years.

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4.1 The Timeline

Suppose you’re still feeling generous and

have agreed to lend your brother
$10,000 today. Your brother has agreed to
repay this loan in two installments of $6000
at the end of each of the next two years.

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4.1 The Timeline

Suppose you’re still feeling generous and

have agreed to lend your brother
$10,000 today. Your brother has agreed to
repay this loan in two installments of $6000
at the end of each of the next two years.

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Textbook Example 4.1

Suppose you must pay tuition of $10,000

per year for the next two years. Your
tuition payments must be made in equal
installments at the start of each semester.
Given that one year has two semesters.
What is the timeline of your tuition
payments?

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Textbook Example 4.1 (cont’d)

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4.2 Three Rules of Time Travel

• Financial decisions often require combining

cash flows or comparing values. Three
rules govern these processes.

Table 4.1 The Three Rules of Time Travel

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The 1st Rule of Time Travel

• A dollar today and a dollar in one year are

not equivalent.
• It is only possible to compare or combine
values at the same point in time.
– Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more.
One factor to consider: How long is “later?”

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The 2nd Rule of Time Travel

• To move a cash flow forward in time, you

must compound it.

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The 2nd Rule of Time Travel

• To move a cash flow forward in time, you

must compound it.
– Suppose you have a choice between
receiving
$1,000 today or $1,210 in two years. You
believe you can earn 10% on the $1,000
today. Which choice is better?

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The 2nd Rule of Time Travel (cont’d)

• Future Value of a Cash Flow

FVn  C  (1  r)  (1  r)   (1  r)  C  (1  r) n


n times

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Textbook Example 4.2

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Textbook Example 4.2 (cont’d)

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The 3rd Rule of Time Travel

• To move a cash flow backward in time, we

must discount it.

• Present Value of a Cash Flow

C
PV  C  (1  r ) n

(1  r ) n

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Textbook Example 4.3

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Textbook Example 4.3

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Applying the Rules of Time Travel

• Recall the 1st rule: It is only possible to

compare or combine values at the same
point in time. So far we’ve only looked at
comparing.
– Suppose we plan to save $1000 today, and
$1000 at the end of each of the next two
years. If we can earn a fixed 10% interest rate
on our savings, how much will we have three
years from today?

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Applying the Rules of Time Travel
(cont'd)

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Textbook Example 4.4

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Textbook Example 4.4 (cont’d)

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4.3 Valuing a Stream
of Cash Flows (cont’d)

• Present Value of a Cash Flow Stream

N N
Cn
n  (1  r)
n
PV   PV (C
n 
0
)  n  0

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Alternative Example 4.5

• Problem
– What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0 1 2 3

$2,000 $2,000 $2,000

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Alternative Example 4.5 (cont'd)
• Solution 0 1 2 3

$2,000 $2,315
x 1.05 x 1.05 x 1.05

$2,000 $2,205
x 1.05 x 1.05

$2,000 $2,100
• Or x 1.05
$6,620

0 1 2 3

$2,000 $2,000 $2,000

x 1.05
$2,100
$4,100
x 1.05
$4,305
$6,305
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x 1.05